The causes of that crisis are well known - a bubble economy, speculation, and opaque accounting. What is less known is the breadth of this crisis. Not only does it affect banks and other financial institutions to an extent no one yet fully knows, but Japan has accumulated a public debt that is now estimated to be a quarter of the GDP of the entire world!
Gavan McCormack, Japanese history professor at Australian National University, warns in New Asia Pacific Review that this debt will total 1,400 trillion yen by 2005, the equivalent of two years' salary for every Japanese citizen. 'For this debt to be repaid smoothly, there are only a few possibilities: high growth, high taxes, or high inflation,' he says.
This is the brewing storm forcing Japan's leaders to start finding ways to close its revenue-expense gap, and to do so with the least political cost. That directly implicates cross-border aircraft finance, especially the Japanese leveraged lease (JLL).
Tokyo tax officials have consistently hated the JLL to the same degree that foreign airlines have loved it. In the late 1980s, when the annual value of JLLs soared to $9 billion, Japan's tax authorities threatened to gut the JLL. In 1990, when airlines financed another $8 billion with JLLs, the Japan Leasing Association agreed to government guidelines reducing JLL tax benefits. JLL volume fell during and after the Gulf War, but soared again to nearly $6 billion three years ago. By then JLLs were financing 40 per cent of the world's new aircraft. Then last year a new tax advisory council started looking again at 'loopholes,' including the depreciation that drives the JLL's popularity with local investors. Word leaked that this council would recommend changes that would effectively end the JLL.
Whether that proved too complex or too great a political hot potato is unclear, but the leasing industry fought to protect accelerated depreciation. Atsunori Horiuchi, head of the Long Term Credit Bank of Japan's aircraft finance division, warns: 'If the depreciation method were changed to straight line it would have a mega-impact on the industry.'
In any event last December when the government was drafting its budget for this year, the council ran out of time and decided to defer depreciation proposals another year. That gave JLLs a reprieve until at least April 1998, the start of Japan's next financial year. For Japan's last financial year, JLL volume dropped to $4.8 billion, due to competition from Germany and its own uncertainty.
Financial reform is clearly in the air. Since his election, prime minister Ryutaro Hashimoto has been pushing to deregulate Japan's banking, securities and insurance industries. Ironically, his aim is to stem a shift of financing activity offshore. Yet, if the tax reforms rumoured last year were adopted, they would accelerate the exit of tax-based aircraft finance.
New tax commission
The fate of the JLL is now in the hands of a new commission. Last year's advisory council - comprised of accountants, professors, and public representatives - still functions but has been preempted on corporate tax issues. Following a return to power early this year, the ruling Liberal Democratic Party (LDP) appointed its own commission comprised of Diet members. Horiuchi explains: 'As a result of the general election, the LDP's tax commission now has the leadership on this issue.'
Horiuchi predicts this commission, which began weekly meetings in June, will release its recommendations by September - well before the December deadline for next year's draft budget. Its recommendations are likely to carry more weight than those of the advisory council simply because this group consists of respected Diet members who are politically astute and focusing specifically on corporate taxes. Even so, Horiuchi believes the group is addressing 38 different issues.
Buoyant market
The new commission also differs in one other major respect - so far it has allowed no leaks. Thus, what it will recommend depends on how one reads the broader signs.Tea leaves aside, the views of those closest to JLLs differ. Bertrand Grabowski, who heads the Asian aerospace group for Banque Indosuez in Tokyo, is one of the most optimistic. 'My opinion is that Japanese tax authorities are not going to kill the JLL because they fear that would eliminate any role for Japan in future cross-border finance. If JLLs disappear, the competitive advantage of Japanese institutions will disappear from a market that is recognised as buoyant for the next five years.'
Grabowski notes the conflict between Japan's need for more tax revenue and the effect the JLL's demise could have on its battered banks. Others may view the tax benefits of JLLs as a loophole, but he sees them as a discreet way to help Japan's still bleeding banks.
Some financiers outside Japan share this view. Paul Steinhardt, managing director of Deutsche Structured Finance and Leasing in Frankfurt, says: 'I don't think the Japanese tax authorities will make this change. The JLL market is too big. And this would hurt Japan's banks at a time when they already have problems.'
Mark Schultz, finance lawyer at Perkins Coie in Seattle, also sees the conflict. 'On the one hand, Japan wants to cut its horrendous deficit by increasing tax revenue. But on the other hand, some of the people who are hurt with all the real estate problems - leasing companies, and to a great extent the banks - are the same people who are helped by the JLL. So how do you balance all of that?'
Yoshihiro Ueda, who manages the project finance group in Dai-Ichi Kangyo bank's international finance division in Tokyo, thinks last year's advisory council hurt itself by attacking depreciation too broadly, drawing strong fire from the leasing industry. This year's proposal, he believes, will be more precise. 'Now the rumour in the market is that the commission has narrowed its proposal to concentrate only on the JLL,' Ueda says. It is politically easier for tax authorities to close benefits that mostly flow offshore, he says. 'Why should a pachinko parlour owner avoid taxes because he's depreciating an airplane that's flying somewhere else and in which he has no real economic ownership?' asks a finance lawyer rhetorically.
Some US finance lawyers share Ueda's view that the Japan Lease Association and tax authorities may compromise by changing depreciation only on cross-border JLLs and leaving domestic leases alone. Yet, LTCB's Horiuchi foresees hurdles in trying to single out JLLs or even leases generally. 'It will be very difficult to change completely the method to straight line[depreciation] just for leased assets, differentiating from any other assets,' he warns.
Civilisation may be suspended on a spider's web of fine distinctions, as British writer G K Chesterton once noted, but clever lawyers will surely seek ways to unspin any distinction between depreciation for leased and non-leased assets, especially when the debate over what is really a 'lease' has been raging for years.
If the tax commission had accepted the latest Ministry of Finance assessment in early July, it might have stopped worrying about harming Japanese banks. The MOF said bank health is improving with problem loans down dramatically. But soon afterwards a major construction company failed, leaving $4.45 billion in bad loans. Worse, banks had not disclosed any of them as problems. Such mixed signals hardly offer a sound basis for policy decisions.
Lost tax benefits
When word first leaked last year about proposed JLL changes, some lessors put clauses in their documents requiring a lessee to reimburse them retroactively for any lost tax benefits. But lessees have largely resisted such attempts to make them guarantors on Japanese tax risks. Most parties have proceeded on the basis or hope that even if the JLL is wiped out, the change will not reach back to existing deals.
Indosuez's Grabowski points to the changes wrought by the JLL guidelines: 'Defeasance was disallowed in 1990, but all the transactions completed before are still alive. They have not been disqualified.' Any further change, he concludes, would be treated the same. But Dai-Ichi's Ueda cautions: 'There has been no change in the tax laws [affecting JLLs] for the last 10 years. The only change has been in the understanding between leasing companies and the national tax authority. This will be the first time there is a change in the tax law itself.' LTCB's Horiuchi also warns: 'There is no written rule or certain assurance that existing JLLs would be grandfathered.'
Daniel Foote, professor of East Asian legal studies at the University of Washington, agrees. 'The criminal context is quite clear. The Japanese constitution states that no person shall be criminally liable for an act that was lawful at the time it was committed.'
'There's another constitutional provision relating to taxes. Article 84 says: "No new taxes shall be imposed or existing ones modified except by law and under such conditions as the law may prescribe." This suggests no retroactive application, but is not nearly as precise as the criminal provision.'
If it is true that no rule can stop Japan's Diet from changing tax laws retroactively, finance lawyers take a practical view. Mark Schultz, who has lived in Tokyo and worked with Japanese counsel on many deals, says: 'I'd be very surprised if they made any change retroactive. It's enough of a struggle just to change the rule, much less then penalise somebody because they were abiding by the rules you told them about before.'
Shrinking role
Assuming existing deals were sheltered, the demise of the JLL may not have too serious an effect on Japan's future as an aircraft financier.
Japan's role has already been shrinking. Japanese banks have been easing out of the JLL business for several years. In Japan's last financial year only five of them, compared to nine a year before, loaned as much as $200 million for the debt portion of JLLs. 'You have to wonder if that's the kind of business they want to do any more,' says one aircraft financier.
JLL lessees are not required to use Japanese banks for the debt portion of a JLL and a growing number of them are not. Foreign banks (many with Tokyo branches) are taking a bigger chunk of this business, accounting for nearly 40 per cent of all JLL debt participation during Japan's last financial year.
By contrast, Japan-based operating lessors remain active. Some, such as Orix, earn significant sums as JLL arrangers, but also have large portfolios of leased aircraft. Many Japanese lessors are incorporated offshore where tax laws are more favourable, such as Singapore or Ireland, but base operations in Japan because their capital comes from Japanese banks or trading companies. Others, such as Sumitomo Trust's Boullioun Aviation or its Singapore joint venture, Sale, are based offshore. Generally, however, Japanese operating lessors face no special obstacles because they are Japanese.
Long term debt finance - the final form of support Japan has typically offered airlines - faces a less certain future. Here Japan's role is in steady retreat for several interrelated reasons.
First, despite rosy MOF reports, Japan's banks still face serious problems. Australian National University Professor Gavan McCormack puts them in perspective: 'Despite the glitter of Japan's contemporary prosperity, the losses contingent upon the collapse of the bubble are comparable in financial terms with those [Japan] experienced 50 years ago as a result of war and defeat.'
The premium paid by Japanese banks for interbank loans of US dollars - the world currency of aircraft finance - is creeping up again. It now ranges from 9 to 15 basis points over Libor for first tier Japanese banks. Weaker banks are simply priced out of the market. This comes at a time when long-term loan rates have grown so competitive that airlines such as Colombia's Avianca are shifting fleet policies from operating leases to ownership because borrowing is as cheap as leasing.
Japanese banks are simply unable to compete on loans to the better credit carriers. The interbank premium pushes them towards higher risk airlines where the spreads still offer some margin. But, as one financier points out, 'All these banks face BIS [Bank of International Settlements] pressure to reduce rather than expand their loan portfolios,' due to non-performing loans. They are especially not interested in more poor credit airlines. The result is that more Japanese banks are closing aviation departments and moving into what they see as lower risk investments, such as European securities.
Sweeping reforms
Finally, Prime Minister Hashimoto is determined to deregulate Japan's financial sector. Eventually this may restore competitiveness, but the short-term effect will be anything but that. The 'Big Bang', so-called after London's comparable reforms several years ago, starts next April with deregulation of foreign exchange and autonomy for Japan's central bank. Further sweeping reforms will follow. Asia Money predicts that Japan's financiers 'will experience severe dislocation before adjusting to [these] new market conditions.'
The sky may not fall with any demise of the JLL, but Japan must put its house back in order before it can assume a larger role in aircraft finance.
Source: Airline Business
